The 5 Education Withdrawal Rules You Need to Know

7/13/2017

Saving for your own retirement and your child’s future college expenses can be a challenge for many parents. With the cost of college on the rise, parents and prospective students are looking to retirement accounts, such as an individual retirement account (IRA), to pay for school. If you’re facing big tuition bills, you’re generally able to take a taxable distribution, penalty-free, from your IRA before you reach 59.5 as long as you use the funds for qualified higher education expenses.

If you’re considering using an IRA to pay for higher education expenses, here are five IRA withdrawal rules you need to know:

The distribution must be used for qualified expenses.

Typically, withdrawals before age 59.5 would result in a 10 percent early distribution penalty in addition to any regular income tax due. Circumstances such as a down payment on a first home or higher education expenses are exceptions. The portion of the distribution used for qualified higher education expenses is exempt from the 10 percent early distribution penalty. You’ll still pay income tax on the portion of the distribution that would otherwise have been subject to income tax, however you’ll avoid the 10 percent additional tax on early IRA distributions.

To be eligible to use this distribution for higher education, the expenses must be for yourself, your spouse, your child or your grandchild. With these funds, you can pay for books, tuition and other qualified education expenses as long as the student is enrolled more than half-time at an eligible institution, as defined by the Department of Education.

Roth IRAs and traditional IRAs follow different guidelines.

A traditional IRA is funded by pre-tax dollars, while a Roth IRA is funded by post-tax dollars. Both traditional and Roth IRAs allow you to withdraw money for qualified higher education expenses before 59.9 without incurring the 10 percent early withdrawal penalty.

The amount of your IRA withdrawal cannot exceed the amount of your qualifying expenses. When money is withdrawn from the account to pay for college-related expenses, the entire amount withdrawn is then subject to income tax. Any withdrawal of funds over the amount for qualified higher education expenses is subject to a 10 percent penalty.

Withdrawals on the principal on a Roth IRA held for at least five years are tax-free if the earnings are not withdrawn. If the account holder is over 59.5, withdrawal of both earnings and principal are entirely tax-free.

You can roll a 401(k) into an IRA to pay for school.

If you’re interested in using an IRA to pay for qualified educational expenses, you can take money from your existing 401(k) and deposit it into an IRA. However, once you receive the check from cashing in your 401(k), those funds must be deposited into the IRA within 60 days to avoid paying penalties.

An IRA withdrawal might affect financial aid.

Money held in retirement accounts, such as an IRA, are exempt from being evaluated on the FAFSA for financial aid. However, when you withdraw funds from an IRA account to use towards qualified education expenses, the funds count as income the following year which could impact your financial aid.

You need to file taxes on your distribution.

When you file taxes, you’ll need to fill out a form, usually Form 5329, to report your distribution and note your exception.

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